Bad debts, aging of accounts

Bad debts, also known as uncollectible accounts, arise from ACCOUNTS RECEIVABLE that ultimately prove to be bad credit risks. When an account receivable is determined to be uncollectible, it should be written off—that is, removed from the collection of accounts receivable. Periodically a firm estimates the amount of its bad-debt expense by an aging of its accounts receivable. This requires that the accounts and their outstanding balances be grouped according to their currency (how up-to-date they are): 0–30 days past due, 31–60 days past due, 61–90 days past due, etc. While it varies from firm to firm, there is some length of time overdue beyond which a firm will deem an account to be uncollectible. An aging of accounts also helps the firm to control the amount of its INVESTMENT in accounts receivable. Accounts receivable, which actually represent an investment of a part of the firm’s CAPITAL, are credit sales waiting to be liquidated; the sales have been made, but the cash has not yet been received. If a firm believes its bad-debt expense is too large, it will tighten its credit policy, thereby decreasing the number of potential customers to whom it will sell on credit. Thus, a credit tightening will decrease revenues from credit sales. A lax credit policy will increase credit sales, but it will simultaneously increase bad-debt expense, illustrating the risk/return tradeoff that is prevalent in all business decisions.